In the old days ‘attitude to risk’ was a very simple concept: clients were either ‘cautious, balanced or adventurous’ and woe betide the adviser who strayed outside those three boxes.
There are at least three important aspects to risk that need to be understood when planning with a client. Their risk tolerance – how much risk they will tolerate before the investment ‘ride’ gets too uncomfortable. Their capacity for loss – what levels of investment losses would have a serious impact on the client’s ability to achieve his or her goals. The need for risk – how much risk does the client need to take to achieve the goals they are aiming to achieve. There is no need to take more risk than you need to even if this is below your risk tolerance level.
What is attitude to risk? It’s exactly that – how much risk a client is prepared to take with their investments or savings, in the anticipation of a greater rate of return. Conventional wisdom dictates that the ‘riskier’ an investment the higher the potential rewards. A fund specialising in say, South Korean smaller technology companies is far riskier than one investing in the shares that make up the FTSE-100 index, but it brings a far higher potential reward.
Critics of this approach will, however, point to UK Income funds – which a few years ago were reckoned to be cautious funds as they contained large holdings in the UK banks. Could anything be safer and more reliable – and more guaranteed to produce steadily increasing dividends – than the shares of Lloyds TSB, RBS and Barclays? Sadly, far too many investors received a very painful answer.
Determining a client’s attitude to risk is a complex area of financial planning. Ask most people and they’ll tell you that they are risk-averse – but sometimes their financial planning goals will determine that they have to accept some risk as they need a higher return on their investments.
There’s also a psychological element to risk. A traditional approach to determining attitude to risk was to ask a client what percentage of their original investment they’d be prepared to ‘lose’ before they started to worry. Ten per cent? Twenty? Fifty? In our experience many clients will cheerfully accept a high level of risk when it is a theoretical question: when subsequent valuation shows ‘real’ money has been lost they take a very different view…
The situation is further complicated as clients very often – and quite understandably – have different attitudes to risk for different parts of their overall portfolio. For example, a widow may come to us and say, “This money has to last for the rest of my life, and give me an annual income.” That’s money that she will want investing very cautiously, as the income will need to be predictable and we won’t be able to take any risks with the capital.
However, she may also have some money that she wants to invest for her grandchildren – money that may not be needed for twenty years or more. With that money she may well be prepared to accept a higher level of risk, in the hope of ultimately giving her grandchildren more than a very cautious investment would have realised.
Finally, circumstances change. Health, inheritance, changes in employment, divorce, marriage… There are a legion of factors that can impact upon a client’s financial planning and they will all in turn impact upon the client’s attitude to risk. A client who was once prepared to accept a high level of risk may be forced by circumstances to suddenly become very cautious.
As financial planners, we will always keep a client’s attitude to risk under review. It’s every bit as important as providing a regular update on the value of an investment portfolio – as the investments must always reflect the client’s financial planning goals, and the level of risk they are prepared to accept in order to achieve those goals.
Sometimes – as suggested above – a client may need to accept a higher level of risk than they normally feel comfortable with: or they may need to scale back their expectations. What’s important is that both investment performance and attitude to risk are regularly monitored: both are equally important in determining the overall success of a client’s financial planning.